On Momentum

Recent relative performance history is predictive of an asset’s future return. Stocks, strategies, and asset classes all seem to exhibit this momentum effect.

We have been studying this effect and its relationship to Verdad’s strategy for several months, and we recently met with Professor Jim Liew at Johns Hopkins Carey Business School to discuss the momentum effect and his research into how to harness market sentiment indicators. We recorded part of our conversation as a guest host on the N2 Podcast. You can listen to this conversation on N2’s website or Soundcloud page.

Our research into momentum and trending has shown that Verdad’s strategy, like most strategies, has a strong tendency to trend. In the case of our strategy, this trending follows the course of the high-yield credit cycle. Since 1999, there have been four major periods of tightening in the high-yield market, marked by the bursting of the tech bubble, the global financial crisis of 2008, the euro debt crisis in 2011, and the oil crash in 2015.

During these four periods of tightening in the high-yield market (roughly 30% of market environments), spreads widened in 68% of months and returns of our leveraged small value equities were negative in 47% of months, with the average monthly return during these periods of -2.4%.

During the other 70% of market environments, when spreads were flat or tightening, spreads narrowed in 68% of months and the monthly returns of Verdad’s leveraged equity strategy were positive in 75% of months, with an average monthly return of 4.2%.

Taking the high-yield spread and the return of a leveraged equity strategy together, each month provides very valuable predictive information about the month to follow. See the figure below for a probability tree illustrating this relationship.

Figure 1: Conditional probabilities of high-yield spreads on leveraged equity returns

This month’s leveraged equity strategy returns are strong related to next month’s movements in high-yield spreads. If we know that this past month’s returns are positive, then there is only a 30.8% probability that next month, the high yield spread will widen. Conversely, if we experienced negative equity returns in leveraged equities this month, there is an 82% probability that spreads will widen next month (or an 18% probability that spreads will contract).

We are in a period of tightening spreads, and Verdad has had positive returns every month since and including February. Given historical precedent, we believe this is a strongly positive indicator for the future performance of the strategy, given the strong momentum effects described herein.